TREASURY INSPECTOR GENERAL FOR TAX
ADMINISTRATION

RECOVERY ACT

Evaluation of the
Internal Revenue Service’s Capability to Ensure Proper Use of Recovery Act
Funds

November 27, 2009

Reference Number:2010-41-011

This report has
cleared the Treasury Inspector General for Tax Administration disclosure review
process and information determined to be restricted from public release has been
redacted from this document.

On February 17, 2009, the
American Recovery and Reinvestment Act of 2009 (Recovery Act) was enacted.The provisions in this law are estimated to
cost a total of $787 billion over 11 years.Federal agencies across the country will be
responsible for distributing billions of dollars of Recovery Act funding to
qualified recipients in discretionary and mandatory programs designed to revive
the ailing economy and create a more sustainable future.

The
Obama Administration has asked Federal agencies to ensure Recovery Act funds are
used for authorized purposes and every step is taken to prevent fraud, waste,
and abuse. Congress appropriated $7
million to the Treasury Inspector General for Tax Administration to provide
oversight and conduct audits of the Internal Revenue Service’s (IRS) administration
of Recovery Act programs. The objective
of this review was to assess the IRS’ ability to verify tax return data and
taxpayers’ eligibility for tax-related Recovery Act benefits and credits.

IMPACT ON
TAXPAYERS

The Recovery Act contains 56 tax provisions, 20 individual
taxpayer provisions, and 36 business taxpayer provisions. The individual taxpayer provisions will cost
nearly $252 billion and provide tax relief to working or retired Americans and
their families.The business taxpayer
provisions will cost more than $74 billion and provide several tax relief
incentives for businesses.The IRS is
unable to verify eligibility for the majority of Recovery Act benefits at the time
a tax return is processed.

WHAT TIGTA FOUND

The IRS uses certain methods to verify the accuracy and
eligibility of tax benefits and credits claimed on tax returns.The validation process can occur 1) before a
tax return is processed and before funds have been released or 2) after a tax
return is processed and after funds have been released.

The IRS cannot verify the accuracy of all of the legislated
requirements before the tax return has completed processing for 39 Recovery Act
provisions (13 individual provisions and 26 business provisions).To a great extent, the IRS relies on taxpayers’
voluntary compliance with tax laws to accurately report income and claim only
those tax benefits and credits to which they are entitled.

Verifying specific eligibility requirements for these 39 provisions
would require the IRS to request specific documentation from the taxpayer.The IRS attempts to weigh the potential
burden that requiring this documentation could place on taxpayers when
implementing provisions.In addition,
limitations of its electronic filing program prevent the IRS from transferring
supporting (paper) documentation into an electronic format.

We are not including recommendations in this report.We have ongoing and planned audits that will
focus on specific Recovery Act benefits and credits.We will include recommendations as
appropriate as part of these reviews.

This report presents the results
of our review to assess the Internal Revenue Service’s (IRS) ability to verify tax
return data and taxpayers’ eligibility for tax-related American Recovery and
Reinvestment Act of 2009 (Recovery Act)[1] benefits and credits. This audit was included as part of our Fiscal
Year 2010 Annual Audit Plan under the major management challenge of Implementing
Tax Law Changes.

The Recovery Act provides separate funding to the
Treasury Inspector General for Tax Administration through September 30, 2013,
to be used in oversight activities of IRS programs.This audit was conducted using Recovery Act
funds.

The IRS did not provide a written response
to the draft audit report.

Copies of this report are also being sent to
the IRS managers affected by the report finding.Please contact me at (202) 622-6510 if
you have questions or Michael E. McKenney, Assistant Inspector General for
Audit (Returns Processing and Account Services), at (202) 622-5916.

On February 17, 2009, the American Recovery and Reinvestment
Act of 2009 (Recovery Act)[2]
was enacted. The provisions in this law
are estimated to cost a total of $787 billion over 11 years. Federal agencies across the country will be
responsible for distributingbillions
of dollars of Recovery Act funding to qualified recipients in discretionary and
mandatory programs designed to revive the ailing economy and create a more
sustainable future. The Recovery Act
contains 56 tax provisions, 20 individual taxpayer provisions, and 36 business
taxpayer provisions.

Individual Taxpayer Provisions

The 20 individual taxpayer provisions will cost nearly $252
billion. These provisions provide tax
relief to working or retired Americans and their families and include several refundable
tax credits, a sales tax deduction on motor vehicles, Alternative Minimum Tax (AMT)
relief for middle-income taxpayers, a reduction in taxable unemployment
compensation, a payment for Social Security recipients, a credit for government
retirees, tax credits that promote investing in renewable sources of energy,
and changes to the Health Coverage Tax Credit.

Business Taxpayer Provisions

Although there are 36 provisions amounting to more than $74
billion in costs which are targeted for businesses, this report will focus on
26 that directly affect the filing of tax returns by businesses.These 26 provisions amount to more than $48
billion in costs and reduced revenue to the Government.They provide several tax relief incentives
for businesses, encourage the investment in sources of renewable energy, and
promote the hiring of unemployed veterans. They also allow for the purchase of bonds to
provide for construction, financing, environmental, and manufacturing
improvements.

In
addition, Congress appropriated $203 million[3]
to the Internal Revenue Service (IRS) to oversee the administration of these
provisions. The Treasury Inspector General for Tax Administration (TIGTA) was
provided $7 million to provide oversight and conduct
audits of the IRS’ administration of Recovery Act programs. Figure 1 summarizes the 20 Recovery Act individual
tax provisions. Figure
2 summarizes the 26 Recovery Act business tax provisions.

This review was performed at the Austin Submission
Processing Site in Austin, Texas, the Ogden Submission Processing Site in
Ogden, Utah, and was discussed with the IRS Recovery Act Team responsible for
overseeing the IRS’ administration of the Recovery Act, executives in the
Submission Processing function, and personnel in the Wage and Investment
Division Headquarters during the period June 2009 through September 2009.We relied on the Recovery Act tax legislation,
Vice President Biden’s May 2009 Quarterly Report on the Recovery Act, and other
documents fromRecovery.gov.We conducted this review in accordance with
generally accepted government auditing standards.Those standards require that we plan and
perform the audit to obtain sufficient, appropriate evidence to provide a
reasonable basis for our findings and conclusions based on our audit
objective.We believe that the evidence
obtained provides a reasonable basis for our findings and conclusions based on
our audit objective.Detailed
information on our audit objective, scope, and methodology is presented in
Appendix I.Major contributors to the
report are listed in Appendix II.

The President and Congress have announced their commitment
to spending recovery dollars with an unprecedented level of transparency and
accountability. To accomplish this, the
Obama Administration has established five broad requirements that all agencies
must follow in order to meet crucial accountability objectives. Posted on Recovery.gov, the third requirement
asks Federal agencies to ensure Recovery Act funds are used for authorized
purposes and that every step be taken to prevent instances of fraud, waste, and
abuse. Guidance on identifying,
prioritizing, and mitigating implementation risks associated with implementing Recovery
Act programs is also provided. In
assessing their risks, agencies receiving funds for Recovery Act programs are
asked to consider:

Do they
have sufficient resources to achieve program objectives and ensure awards
are properly made in accordance with statutory and regulatory
requirements?

Are
existing internal controls sufficient to mitigate the risk of fraud, waste,
and abuse?

Implementing
tax legislation

When Congress develops a piece of tax legislation, it considers
and decides which requirements taxpayers must meet to qualify for a given tax
benefit.Such requirements may include
having a certain income level or filing status, having dependent children, having
a certain profession, not being employed, etc. Some requirements limit the time period during
which a given credit or deduction is available. Others require the taxpayer to purchase
something, such as a home with the First-Time Homebuyer Credit or energy
efficient home improvements with the Residential Energy Credit.

Once Congress enacts tax legislation, the IRS reviews the
law to determine what actions it must take to correctly implement the law to
ensure legislated requirements will be satisfied. The IRS Legislative Analysis Tracking
Implementation Services office is responsible for managing the implementation,
planning, and monitoring of legislation having significant impact on the IRS. Actions the IRS takes in response to new
legislation often include creating new tax forms, updating publications, revising
internal operating procedures, and updating programs for processing tax returns.

Methods
the IRS uses to validate tax return data

The IRS uses certain methods to verify the accuracy and
eligibility of tax benefits and credits claimed on tax returns.The validation process can occur 1) before a tax
return is processed and before funds have been released or 2) after a tax return
is processed and after funds have been released.

Before a Tax
Return Has Completed Processing

The ability of the IRS to verify the accuracy and
eligibility of tax benefits and credits before a tax return has completed processing
and prior to release of funds is the most efficient and effective approach for
the IRS.In recent testimony before
Congress, the General Accountability Office stated:

Our work has shown that building
internal controls in up front is of the utmost importance and that fraud
prevention is the most efficient and effective means to minimize fraud, waste,
and abuse. Once federal dollars are
disbursed fraudulently or improperly, the government is only likely to recover
a few pennies on the dollar. Thus,
preventive controls are the most important component of a fraud prevention
system. These controls prevent
ineligible individuals and questionable firms from gaining access to government
funds in the first place.[10]

Preventive identification efforts on the part of the IRS
include the development of computer programs to detect errors on electronically
filed tax returns before they are accepted. Specifically, electronically filed tax returns
are put through a number of validations which check for more than 600 possible
errors before the IRS accepts the tax return. Data files used for data validation include
files from the Social Security Administration and the Department of Defense. When errors are detected, the tax returns are
rejected back to the transmitter to be corrected.Errors include incorrect Social Security Numbers
(SSN) for dependents, incorrect birthdates, numbers in alphabetic fields, and invalid
zip codes.

Once a tax return is received (paper filed) or accepted (electronically
filed) by the IRS, selected information from the tax return is validated and/or
verified by the IRS.Checks include verifying
the mathematical correctness of the tax return and identifying other potential
errors. If a tax return is identified as
not passing validation/verification, the tax return is forwarded to the IRS Error
Resolution function to be manually reviewed and corrected.

After a Tax
Return Has Been Processed

After a tax return has been processed and subsequent to the
release of funds, the IRS has limited means by which it can validate the
accuracy of tax benefits and credits previously claimed. The IRS can match third-party documents to
information listed on the tax return.For example, the IRS receives third-party wage and earnings information
including Wage and Tax Statements (Form W-2) and Miscellaneous Income (Form
1099).The IRS Automated Underreporter
Program matches these third-party documents to wage and earnings reported on an
individual’s tax return to ensure the accuracy of reporting.If a discrepancy exists, the IRS sends
correspondence to the taxpayer for confirmation and submission of additional
tax owed.For business taxpayers, recent
legislation requires credit card companies to provide information to the IRS
regarding businesses that receive credit card payments.The IRS expects to be able to use this
information to match against income that businesses report on their tax
returns.

In addition, the IRS can perform an audit of the taxpayer
records by a field examination, office audit, or correspondence audit.Field examinations include reviews of complex
issues that require a face-to-face interview at a taxpayer’s home or business. Office audits are conducted at local IRS
offices and focus on less complex issues than field examinations but more
complex issues than correspondence audits. Correspondence audits focus on simple issues
on individual tax returns and are conducted by mail. In all cases, taxpayers are asked to provide the
documentation necessary to verify a variety of selected issues that may include
certain tax benefits and credits claimed on a tax return.

The IRS cannot verify the accuracy of all of the legislated
requirements for 13 of the 20 Recovery Act tax benefits/credits for individual
taxpayers and all of the 26 provisions for businesses before the tax return has
completed processing.The IRS relies on taxpayers
to comply with tax laws and provide correct information on their tax returns,
including accurately reporting income and claiming only those tax benefits and
credits to which they are entitled.Verifying
specific eligibility requirements for these 39 provisions[11]
would require the IRS to request specific documentation from the taxpayer.

Figure 3 summarizes Recovery Act tax provisions that affect individual
taxpayers and Figure 4 summarizes Recovery Act tax provisions that affect
business taxpayers.These figures show whether
the IRS can verify all the requirements included in the tax legislation that a
taxpayer must meet to qualify for the Recovery Act tax benefit or credit before
the tax return has completed processing or after the tax return has been processed.
Some of the provisions are not included
in these figures as noted below:

In Figure
3, 3 of the 20 individual provisions are not included.These include a one-time, $250 payment
to Social Security, disability, and railroad retirement recipients which
the Social Security Administration is responsible for issuing.The remaining two provisions (Computers Allowed
as Education Expense for Education Savings Accounts and Increased Exclusion
for Employer Provided Commuter Transit Costs) are not reported on an
individual tax return. In addition,
we combined the two AMT provisions on one line.

In Figure
4, 10 of the 36 business provisions are not included because they do not
directly affect the filing of tax returns by businesses.

Individual and business provisions have multiple
requirements that have to be met to qualify for the tax benefit or credit.For a number of Recovery Act provisions, the
IRS can verify many of the requirements that need to be met to qualify for the
tax benefit or credit before a tax return has completed processing.In Figures 3 and 4:

·A “No” in column two indicates that the IRS
cannot verify one or more of the requirements to qualify for the specific
provision.

·A “Yes” in column two indicates that the
specific Recovery Act requirements can be computer validated before a tax
return has completed processing.A “Yes”
followed by an asterisk (*) indicates that other requirements from previous non-Recovery
Act legislation relating to the Recovery Act tax benefit or credit cannot be
validated.For example, the IRS can
validate the Recovery Act requirement that provides for an increase in the Earned
Income Tax Credit for individuals with three or more children.However, to be eligible for the Earned Income
Tax Credit, the following requirements must be met:

·The qualifying child (or children) must have
lived with the taxpayer in the United
States for more than one-half of the tax
year.[12]

·If the taxpayer does not have a qualifying
child, the taxpayer must have lived in the United States for more than
one-half of the tax year.[13]

The above requirements cannot be validated without an audit of the taxpayer’s
records.

A “N/A” in column
three indicates that the specific Recovery Act requirements for this provision
cannot be verified by a third-party document (e.g., a Form W-2 or Form
1099-INT) because no such document is reported to the IRS.However, a “N/A” followed by an asterisk
(*) represents that one or
more requirements from past (non-Recovery Act) legislation for this Recovery
Act tax benefit or credit can
be verified by a third-party document.

Increase in Hope Credit (also known as The American Opportunity Tax
Credit)

****2(f)****

****2(f)****

Yes

Increase in First-Time Homebuyer Credit

****2(f)****

****2(f)****

Yes

The First $2,400 of Unemployment Compensation Is Nontaxable

****2(f)****

****2(f)****

Yes

Additional Deduction for State Sales Tax on Certain Motor
Vehicles

****2(f)****

****2(f)****

Yes

AMT Relief (2 provisions)

****2(f)****

****2(f)****

Yes

Modification of Nonbusiness Energy Property Credit

****2(f)****

****2(f)****

Yes

Modification of Residential Energy Efficient Property Credit

****2(f)****

****2(f)****

Yes

Qualified Plug-In Electric
Drive Motor Vehicles Credit

****2(f)****

****2(f)****

Yes

Certain Plug-In Electric Vehicles Credit

****2(f)****

****2(f)****

Yes

Conversion Kits

****2(f)****

****2(f)****

Yes

Treatment of Alternative Motor Vehicle Credit as a Personal
Credit Against the AMT

****2(f)****

****2(f)****

Yes

Expansion of Health Coverage Tax Credit

****2(f)****

****2(f)****

Yes

Special $250 Credit for Certain Government Retirees

****2(f)****

****2(f)****

Yes

Source:Pub. L. No. 111-5, 123 Stat. 115 (2009).

The
requirements for business tax returns can be even more difficult to validate due
to the complexity of the tax returns and the number of supporting schedules and
documents associated with the tax returns.In most cases, it would be very burdensome to require a business to
include all the necessary supporting documentation to validate the claim at the
time the tax return is filed.

Figure 4:Assessment of the IRS’ Ability to Verify the
Accuracy and/or
Eligibility of Recovery Act Business Taxpayer Provisions

The IRS attempts to weigh the potential burden that
providing documentation can place on taxpayers when implementing
provisions.In addition, limitations of its
electronic filing program prevent the IRS from transferring supporting (paper)
documentation into an electronic format.For example, on November 25, 2008, we issued a memorandum to the
Commissioner, Wage and Investment Division, and recommended that the IRS
require taxpayers to provide documentation to verify the purchase of a house
for the purpose of claiming the First-Time Homebuyer Credit.In response, the IRS stated that our
recommendation would be unnecessarily burdensome and would potentially exclude
as many as 2 million taxpayers from electronically filing.

It should be noted that the IRS was not provided with math
error authority[17]
to stop the payment of erroneous First-Time Homebuyer Credit claims.As such, if the IRS identifies an erroneous
claim, an audit must be performed.The
TIGTA has reported previously on the benefits of expanding math error authority
to allow the IRS to disallow taxpayer claims at the time a tax return is
processed.[18]As of July 25, 2009, we have identified 73,799
taxpayers who may have incorrectly claimed $504 million in the First-Time
Homebuyer Credit.Expansion of math
error authority would allow the IRS to efficiently disallow erroneous taxpayer claims
during the processing of a tax return and prior to the release of funds.

We are not including recommendations in this report.We have ongoing and planned audits that will
focus on specific Recovery Act benefits and credits.We will include recommendations as
appropriate as part of these reviews.

The overall objective of this
review was to assess the IRS’ ability to verify tax return data and taxpayers’
eligibility for tax-related American Recovery and Reinvestment Act (Recovery
Act)[19] benefits and credits. This review is being conducted in response to
the mandate that agencies ensure Recovery Act funds are used for authorized
purposes and steps are taken to prevent instances of fraud, waste, error, and
abuse.To accomplish our objective, we:

1.Evaluation of the Planning, Computation, and
Issuance of the Recovery Rebate Credit (Reference Number 2009-40-129, dated
September 9, 2009).

The TIGTA identified that
legislation did not provide the IRS with math error authority to prevent
individuals without valid SSNs from receiving the recovery rebate credit.Although the legislation prohibited
individuals without a valid SSN from receiving the rebate credit, the IRS was
not provided with math error authority that would have enabled it to
effectively prevent the issuance of rebate credits to these individuals at the
time a tax return was processed.As a
result, the IRS erroneously provided more than $27 million in recovery rebate
credits to more than 44,000 taxpayers who did not have a valid SSN.

The TIGTA issued a memorandum to
the IRS in September 2008 raising concerns about its lack of math error
authority.We recommended the IRS work
with the Assistant Secretary of the Treasury for Tax Policy to obtain math
error authority for recovery rebate claims on tax returns without a valid SSN.IRS management responded that they had raised
concerns to the Assistant Secretary about the lack of math error authority for
this issue.However, no legislative
proposal was put forth to provide this authority.

2.Actions Are Needed to Ensure
Proper Use of Individual Taxpayer Identification Numbers and to Verify or Limit
Refundable Credit Claims (Reference Number 2009-40-057, dated March 31, 2009).

The TIGTA identified taxpayers without a valid SSN receiving potential
Additional Child Tax Credits of almost $1.8 billion on more than 1.2 million tax
returns and recommended legislation to clarify whether or not refundable tax
credits such as the Additional Child Tax Credit may be paid to filers without a
valid SSN and, if these credits may not be paid, to provide IRS math error
authority to disallow associated claims for the credits.Disallowance of the Additional Child Tax Credit
to filers without a valid SSN would reduce Federal outlays by $8.9 billion over
5 years.The IRS agreed to explore with
the Department of the Treasury legislative changes to address the payment of
refundable credits to taxpayers who file without an SSN.

3.The Earned Income Tax Credit Program Has Made
Advances; However, Alternatives to Traditional Compliance Methods Are Needed to
Stop Billions of Dollars in Erroneous Payments (Reference Number 2009-40-024, dated December
31, 2008).

The TIGTA identified the IRS could address $5.6 billion
in erroneous claims over a 5-year period if it was able to systemically adjust
the Earned Income Tax Credit claims with math error authority processing.However, the IRS does not plan to pursue
expansion of math error authority to include these cases because it believes
that use of probability filters to identify these cases is inconsistent with
math error authority.The TIGTA
recommended the IRS conduct a study of alternative processes that will expand
the IRS’ ability to identify and adjust erroneous Earned Income Tax Credit
claims for which data show that the taxpayer does not meet the Earned Income Tax
Credit qualifying-child relationship and/or residency tests.The IRS agreed to continue its ongoing
efforts to identify new alternatives to expand its treatment of Earned Income Tax
Credit errors.These efforts include
conducting a study of the Federal Case Registry information to determine its
accuracy and applicability for exercising existing math error authority to deny
the Earned Income Tax Credit during upfront processing of the tax return.

4.The 2008 Filing Season Was Generally
Successful Despite the Challenges of Late and Unexpected Tax Legislation (Reference
Number 2008-40-183, dated September 30, 2008).

The TIGTA identified taxpayers
age 70½ or older who improperly claimed and were allowed the Individual
Retirement Account deduction and recommended the IRS ensure that the computer
systems were programmed to identify taxpayer tax returns claiming Individual
Retirement Account deductions for taxpayers age 70½ or older.However, IRS management did not agree citing
that they did not have math error authority to enforce this condition.

[14]
Although the IRS can ensure, through computer verification, that the two Recovery
Act requirements related to this provision are validated, the issue of whether
a taxpayer has tax preference items and owes the AMT cannot be validated
upfront during processing.

[15] Debt
Instrument Rule Changes and the Modification of
Tax-Exempt Interest Expense Rules of Financial Institutions include 2
provisions each for a total of 26 provisions.